Collateral Constraints and the Amplification Mechanism

Collateral Constraints and the Amplification Mechanism

Journal of Economic Theory. August
2003, Vol. 111, Issue 2, Pages 277-292

Kiyotaki and Moore (J. Polit. Economy 105 (1997) 211) have offered a theory for how common shocks to credit-constrained firms are amplified through changes in collateral values and transmitted as fluctuations in output. I clarify and extend their model by showing that their collateral amplification mechanism is not robust to the introduction of markets that allow these firms to hedge against common shocks. A theory of incomplete hedging is proposed in which the supply of hedging available in the economy is constrained by the aggregate value of collateral. I illustrate how the constraint reinstates amplification effects and discuss empirical implications of this new mechanism.